Class act or is it for real?

Even state organizations cannot agree on the size of China's middle class, which sprung up from nowhere in a decade. The Chinese Academy of Social Sciences (CASS) puts it at a modest 35m (Canada and change) while the National Bureau of Statistics says it numbers 75m (Germany roughly). But foreign estimates really supersize projections – KPMG, for instance, reckons the middle class runs to 100m (Mexico), French bank BNP Paribas to 150m (Japan and change).

Whatever the number, the more optimistic analysts expect the middle class will double every five years, given China's galloping GDP (just pulling back to 8% annual growth from an average 9% over the last 20 years). So at that pace it will hit 300m by 2010 by BNP Paribas's count – basically one USA. "It's up from nothing five years ago," says Joe O'Mara, KPMG's China chief. "Growth of the Chinese middle class is exponential."

O'Mara defines a middle-class Chinese as anyone who owns a home, a car, can send his children to a decent school, and can buy a Haagen-Dazs when he wants one. A middle class person, he says, can travel, at least domestically, and shop for the real thing and not have to buy knock-offs.

Different definitions
The term "middle class" in China, like the term "middle age," does not mean the middle of anything. "There will be no real middle stratum in China if most farmers are excluded from the group," Song Linfei, president of the Jiangsu Provincial Academy of Social Sciences, was quoted as saying in the China Daily.

Indeed, to read CASS analyst Li Chunling in the same China Daily report, it is little more than marketing hucksterism. "The so-called Chinese middle class is nothing but a myth and a bubble conjured up by media organizations and researchers," she sneered, asserting that only 2.8% of the population could possibly qualify.

China's 786m farmers, she said, represent 70% of the population and their average per capita annual income is RMB2,622 (US$317). Rural folk, she says, only buy 39% of goods and hold 19% of individual savings.

Of course, that suggests there is still a good portion of China's population that spends a lot and puts a lot of money in the bank. BNP Paribas sets its middle class admission bar at RMB25,000 per annum.

What is beyond doubt is that salaries have been rising for more people as productivity soars. "The rise in income levels has been the key driver in China's recent boom in housing, auto, pharma and telecom markets," notes Allan Zhang, associate director, transaction services, at PricewaterhouseCoopers in Beijing.

In a January report looking at Chinese and Indian retail markets, PwC said the rise of these affluent consumers is changing consumption patterns overall, and that now consumer goods companies actively contribute to "building the middle class in China."

Coastal class
Shanghai wields the middle-class clout; its economy grew 10.8% year-on-year, to RMB180bn, in this year's first quarter – despite central government efforts to slow growth to a canter. Clamping down on lending had some impact: first-quarter GDP growth for the city was 9.5%, well down from last year's 13.6% full-year figure – in fact it only matched nationwide growth for the quarter, not typically what cities considered growth drivers do.

But it is Shanghai and other coastal cities from Dalian in the north to Guangzhou in the south that are getting richer faster and it is in these cities where the middle class congregates in the greatest numbers, leaving much of the interior bereft of SUVs, flat screen TVs and smart shops.

One rule of thumb says that when 50% of the population is urban and the service sector accounts for more than 50% of the economy, the middle class starts becoming a force in the land. Official policy calls for China to be nearly 80% urban by 2020, but it is still only 40% citified now, while services still only account for 32% of GDP.

Chang Xiuze of the Academy of Macro- Economic Studies already sees more of a wave than a ripple in all this. In a recent China Daily report, he called middle-class dollar volume "stupendous" and predicted it will lift growth of domestic consumption for all. "The upgraded consumption structure will soon trigger a restructuring of the country's industrial sectors to benefit overall economic development," he said.

KPMG's O'Mara agrees. "Private ownership has unleashed so much. People have equity in their homes, and more financing is available, and more wealth has been created. In Shanghai, sales-per-square-foot has reached levels that match numbers in the US.

"It looks fantastic for retail, and travel is great, too. There were 25m in tour groups traveling outside China last year. That's up from nothing five years ago."

While sounding a hopeful note, Beijing-based Stoyan Tenev, lead economist for East Asia and the Pacific for the World Bank's International Finance Corp, warns against conflating the developed world's notions of what a middle class is with what exists in China. "Investment banks tend to look at purchasing power," he cautions. "Defined this way, it refers only to the top echelon of society.

"Remember that China was able to embark on a road to prosperity by consciously accepting development in certain areas. Deng Xiaoping said if China wants to be rich, inequality is inevitable and should be socially acceptable."

Up to a point: Tenev notes China's present high degree of social mobility and recalls Deng's timetable for righting major imbalances – hence the current leadership's focus on disadvantaged provinces.

"They do not tolerate unfair ways of becoming rich," he says, noting Beijing's clampdown on corruption, as in management buyout (MBO) schemes cooked up by state-owned enterprise (SOE) executives to pick up state assets for a song. "Reform of the administrative system has [also] led to incentives for the bureaucracy. Their opportunities are correlated to overall growth in specific [underdeveloped] localities," Tenev says. "This is key to maintaining China's dynamism in the future."

Financial services
The banks certainly see the possibilities created by China's middle class. "China certainly appears ready for plastic," says David A. Von Emloh, Shanghai-based principal of management consultants McKinsey & Co. He argues the number of households bringing in US$6,500 a year will increase tenfold by 2010 to 30m – or 90m people.

Retail banking, fully open to foreigners by 2007, should be at cruising altitude by then. In a report on the sector, Emloh says foreign financial services companies could be earning between US$3bn and US$5bn, or perhaps even more by 2010, with mortgages and personal-lending earnings likely to grow 30% a year. "This would be almost equal to the annual revenues of Taiwan's credit card industry," he said.

And since three-quarters of affluent customers live in Beijing and in major coastal cities, foreign banks will only need a small number of branches in a few big cities, he said. "Citibank and HSBC are building their own branch networks in central locations in Shanghai, luring top customers. For now, these branches are limited by regulation, but come 2007, they will be free to take local-currency deposits and to offer renminbi-denominated credit cards."

Bonn Liu, KPMG's financial services partner in Hong Kong, likes prospects for mutual funds, recalling how ING, Fortis, Allianz, Invesco and SocGen together raised RMB 200bn in just two months earlier this year. "That demonstrates an appetite for financial products," he says. "There is a high savings rate [20% versus 1.6% in the US] and a desire to not see the money sloshing around in banks at low interest rates."

And that's only one of the bright spots. Liu notes that China's equities investment rate is low at 10% – far from the 40-50% rate of the developed world, which is where it could be when serious market reforms kick in. China boasts the world's worst performing major market, despite the fact China's is the planet's fastest growing large economy – a legacy of deadwood companies, lack of transparency and the huge overhang of government-held non-tradable shares that investors rightly fear could shrivel the worth of existing tradable shares to nothing when Beijing finally dumps them on the market. Liu puts it more diplomatically: "Performance has not been good."

But news came on May 12 to brighten the picture from Xinhua News Agency: Beijing announced it would no longer bail out smaller state-owned enterprises and would tell them to file for bankruptcy if they can't pay their bills. At the same time, government support would continue for bigger failing SOEs, particularly those in the poorer northeast and inland areas.

Jeremy Ngai, a senior tax manager at PwC, calls China's progressive tax rate, which starts at 5% and rises to 45%, "very high" compared to Hong Kong's 16%. "Progressive taxes will continue to have a significant contracting effect on the disposable income of the middle class."

Indeed, KPMG tax partner Peter Kung says things look good for China's exchequer – with 15% of taxpayers in the 20-29 age bracket and 18% in the 30-39 age bracket. "This group provides the university graduates and the young entrepreneurs. Ten years ago, if you earned RMB10,000 a year, you were rich," he says. "These days, young people coming out of university can earn that in a very short time working for multinationals and other foreign companies and they are big spenders, receptive to credit."

Tax growth, Kung says, has surpassed GDP growth. "GDP runs around 9%, but the tax revenue growth rate is about 25%. Ten years ago the tax rate and the GDP rate were much the same," he says. Another important factor, Kung adds, is that more and more people are rising into the tax net, which will produce even more revenue.

Where will the money go? "Earnings of civil servants have been lagging, so much of the growth in the tax revenue will be absorbed to close the gap with the private sector. But that's for now – the tax base is always growing, and growing fast," Fung says. And more will undoubtedly go to projects to help have-not provinces catch up.

Retail spenders
Whatever the impediments, be they distribution or regulatory bottlenecks, big foreign retailers are steaming ahead with expansion plans. Well established for the most part on the coast, Carrefour of France, Germany's Metro and world giant Wal-Mart are rapidly opening shop in China's once neglected interior, tracking down middle-class spenders in second-tier cities like Kunming, Xi'an, Wuhan, Chongqing and dozens of others.

Carrefour is the clear leader, with 2004 mainland sales of RMB16.23bn, dwarfing Wal-Mart's RMB7.63bn. In May, Carrefour announced taking a 25% stake in a US$35m Suzhou retail venture. In April, it opened its 60th store, in Chongqing – its fourth opening of 2005. Carrefour plans to open 12 to 15 stores a year, a third of them in China's remote central and western regions. Wal-Mart and Metro have aggressive expansion plans, too.

"China is not an easy market," Carrefour China President Jean-Luc Chereau told the South China Morning Post earlier this year. "It is more like a continent, where the variety of cultures and traditions set up challenges for us in how to adapt to each area."

In another report earlier this year, PwC noted that as consumers get richer, they spend less on food and more on consumer goods, and the tendency seems as evident in China as elsewhere. "In China, the market for furnishings, household appliances and DIY is growing significantly, and higher spending on educational and child-oriented products is forecast," PwC said.

"Sales of high technology communications/ entertainment products, mobile telephony, digital cameras, DVDs and CDs will soar. At the moment, 320m people own mobile telephones in China compared to 50m in India – and these figures are going up every day," the report noted.

But Alistair Watts, managing director of ACNielsen China, sounds a retail alarm: "The number of modern stores is growing faster than sales, and the individual trade share is in decline. Consumer loyalty to individual stores is also low or in decline."

ACNielsen's 2002 Shopper Trends study on young affluent shoppers, aged 25 to 35, opened a window on attitudes and expectations. Watts says young, affluent Chinese have limited leisure time; shopping tends to substitute for leisure and serves as family outings. "They shop more and spend less," he says.

Cars and real estate
China's youth are the big spenders. A survey conducted by the Beijing-based Parents Monthly found young urbanites spend 70% more each year than the per capita city average – RMB 15,288 a year compared to RMB 9,000.

Some of that money goes to buying cars. As an executive of a car franchise selling Mini Coopers and BMWs in Guangdong noted, "They just want a car that matches their status. They are rich and can afford to pay in one go," she added, explaining the company's made-in-China Mini Coopers are specifically earmarked for young trendies.

The new and shiny rule applies to young consumers shopping real estate. Younger buyers "prefer brand-new properties," a Guangzhou property agent told the South China Morning Post. "Most of the time, it's parents who make the down payment."

According to a recent Parents Monthly survey, 32% of young respondents planned to buy a car and 22% a condo within the next 12 months. And condo buying extended to Hong Kong. In May, Mainland Chinese were reported to be in "frenzied pursuit" of Hong Kong property over last month's Golden Week holiday. According to Henderson Land, one of the city's (and China's) top developers, 24m Chinese are capable of paying HK$1m (US$128,338) cash towards a flat.

Travel
As befits a country with a rising middle class, the foreign travel market has been exploding, a process that started when Beijing began phasing out restrictions on individual travel. Chinese now make up the fastest-growing tourism market for Australia. Singapore, which used to demand Mainlanders' bank statements before deigning to admit them, has switched to grovel mode, waiving visa requirements for holders of Visa, MasterCard and Amex Gold Cards.

Hong Kong, every Chinese national's first option for getting his feet wet in "foreign" travel, credits the Mainland for making the city roar again as a travel destination after it was devastated by the SARS epidemic. And, despite the huge cost differentials between the SAR and the Mainland, Chinese keep pouring over the border.

Travel markets across the world are doing their best to be noticed by Chinese with a yen (or dollars, more accurately) to hit the road. KPMG's O'Mara observes that even at Paris' Charles de Gaulle airport, top place in foreign language signage now goes to Chinese.

But the big travel story is about what lies ahead. According to Sumner LaCroix, economics chairman at the University of Honolulu, the number of Chinese who will be able to afford travel (which is an industry Hawaii studies with clinical interest) is 350m to 400m by 2020.

Political plusses and minuses
In the background of China's generally happy story, the income gap widens as Beijing races to pour in money and connect China's middle with the middle-class opportunities exploding on the coast. As more state enterprises are wound up, unemployment will keep rising. More unemployment could come as China moves up the manufacturing food chain and automates more processes. With luck, the unemployed will be absorbed into a broadening services sector.

"There are problems, but as long as the have-nots have hope, it should work out," says Robert Broadfoot, managing director of Hong Kong's Political and Economic Risk Consultancy. "And I have never seen so much hope in China. The Chinese will produce much cheaper items and export them. I think that will shape the course of commerce in the coming century."

He wonders if some foreign investors have a realistic understanding of "middle class." For Chinese, price sensitivity is a real issue, and foreign retailers will run into trouble if they do not recognize this, he says. "When we talk of the middle class, we are not talking about incomes of US$30,000 to US$50,000 like those in the US. It's more like US$2,000 to US$5,000. Retailers will have to keep that in mind," he warns.

And there is also the question of fitting in with the ebb and flow of Beijing's social agenda, for example whether it would tolerate a highly visible number of large, expensive cars. "If the number is too high, the central government will intervene, saying 'we don't have the oil,' or 'we cannot tolerate the pollution.'"

But then there is always China's hopeful side, in the auto industry as most anywhere else. "If China can come up with an inexpensive car of its own, with low fuel consumption and low pollution, they will have one that will not only sell domestically, but reap big export returns."

With that, Broadfoot closes with a classic Chinese story. "Calculators were hugely expensive, before China came up with really cheap ones and sold them all over the world."

Even the world's middle class could afford them. Now there are (take your pick) 35m, 75m, 100m, 150m Chinese who can afford calculators, and other things too.

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